Income Tax Accounting (ASC 740): Deferred Taxes for the CPA Exam
Master deferred tax assets, deferred tax liabilities, and the valuation allowance under ASC 740 for the CPA FAR exam with practical examples and journal entries.
Overview of ASC 740: Income Taxes
ASC 740 governs how entities account for the current and future tax consequences of events recognized in their financial statements. The standard uses the asset and liability method, which focuses on temporary differences between the tax basis and the book (financial reporting) basis of assets and liabilities. Income tax accounting is consistently one of the most tested topics on the CPA FAR exam.
Current Tax Expense
Current tax expense (or benefit) represents the amount of income taxes payable or refundable for the current year. It is calculated by applying the enacted tax rate to current taxable income, which is determined under the applicable tax code. Current tax expense is relatively straightforward; the complexity of ASC 740 lies primarily in deferred taxes.
Temporary Differences
Temporary differences are differences between the tax basis and the book basis of an asset or liability that will result in taxable or deductible amounts in future years when the asset is recovered or the liability is settled. These differences create deferred tax assets (DTAs) or deferred tax liabilities (DTLs).
Deferred Tax Liabilities
A DTL arises when a temporary difference will result in future taxable amounts. Common examples include:
- Accelerated depreciation for tax purposes (book basis of a fixed asset exceeds its tax basis)
- Installment sale receivables (revenue recognized for book purposes before tax)
- Prepaid expenses deducted for tax before they are expensed for book purposes
Deferred Tax Assets
A DTA arises when a temporary difference will result in future deductible amounts. Common examples include:
- Warranty liabilities (expense recognized for book purposes before the tax deduction)
- Unearned revenue (taxable when received, recognized as book revenue later)
- Bad debt expense under the allowance method (book expense recognized before the tax deduction)
- Net operating loss carryforwards
- Tax credit carryforwards
Permanent Differences
Permanent differences are items that are included in either book income or taxable income but never both. These do not create deferred taxes. Examples include tax-exempt municipal bond interest income, nondeductible fines and penalties, meals entertainment (partially nondeductible), and the dividends received deduction. Permanent differences affect the effective tax rate but do not give rise to DTAs or DTLs.
Measuring Deferred Taxes
Deferred taxes are measured using the enacted tax rate expected to apply when the temporary difference reverses. If tax rates change, existing DTAs and DTLs are adjusted in the period the change is enacted, with the effect recognized in income tax expense from continuing operations.
For example, if a company has a DTL of $100,000 measured at a 21% rate and the enacted rate changes to 25%, the DTL is remeasured to $100,000 divided by 0.21 then multiplied by 0.25, which equals approximately $119,048. The increase of $19,048 is recognized as additional income tax expense.
Valuation Allowance
A valuation allowance is established against a DTA when it is more likely than not (greater than 50% probability) that some or all of the DTA will not be realized. The assessment considers both positive and negative evidence, including:
- Future reversals of existing taxable temporary differences
- Future taxable income exclusive of reversing temporary differences
- Taxable income in prior carryback years (if carryback is permitted)
- Tax-planning strategies
The valuation allowance is a contra-asset that reduces the net DTA on the balance sheet. Changes in the valuation allowance are typically reflected in income tax expense.
Intraperiod Tax Allocation
ASC 740 requires that the total income tax provision for a period be allocated among continuing operations, discontinued operations, other comprehensive income, and items charged or credited directly to equity. This is known as intraperiod tax allocation. The tax effect of items outside continuing operations is determined incrementally based on the tax effect of those items given income from continuing operations.
Presentation and Disclosure
All deferred tax assets and liabilities are classified as noncurrent on the balance sheet. A rate reconciliation is required, showing the reconciliation between the statutory federal tax rate and the effective tax rate, either in dollars or percentages. The components of income tax expense (current and deferred, federal and state) must also be disclosed.
Exam Preparation Tips
- Create a systematic approach: identify temporary differences, classify them as DTA or DTL, measure at the enacted rate, and assess the need for a valuation allowance.
- Distinguish between temporary and permanent differences; only temporary differences create deferred taxes.
- Remember that deferred taxes use enacted rates, not expected rates.
- Practice the journal entry: Debit Income Tax Expense, Debit DTA (increase) or Credit DTA (decrease), Credit DTL (increase) or Debit DTL (decrease), Credit Income Tax Payable.
- Understand that all deferred taxes are classified as noncurrent regardless of when the underlying temporary difference is expected to reverse.
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